Recession changes outsourcing model

The credit crunch has produced a new outsourcing paradigm, argues Andy Gallagher

By Andy Gallagher

February 10, 2009

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For some years, credit has been growing faster than economic activity. In 1980, debt levels for US banks were running at 21 per cent of gross domestic product (GDP). By 2007, the figure had grown to 116 per cent of GDP. In Europe, by 2008, bank capital had shrunk to 10 per cent of assets as requirements for capital adequacy were loosened. For most of the 20th century, the figure had been 25 per cent.

Some of that credit found its way onto the balance sheets of outsourcing companies, who used it to finance contracts and offer discounts to CIOs in the early years of a deal.

In some cases, the outsourcing provider not only delivered IT services, they became a source of credit too. Compass Management Consulting analysis of contracts suggests that the discount in the first year of sourcing deals was 15-20 per cent below the market rate. This was offset by a premium of up to 30 per cent above market rate towards the end of the contract term.

With the shrinkage of credit over 2008/2009, these variable price deals are no longer sustainable. At Compass, we are calling this a new sourcing paradigm because its effects are so profound.

One example: today’s economic conditions are the toughest for several generations. Corporations are looking to cut costs like never before and some think they “deserve” discounts because of the slowdown.

Five or 10 years ago, service providers could secure access to funds, provide the discount, ramp up prices in the final years of the deal (by which time the economy was growing again) and both parties were happy.

Not today. In the new sourcing paradigm, service providers are either unwilling or unable to raise cash in order to fund a discount.

About the author

Andy Gallagher is a consulting director responsible for IT service providers at Compass Management Consulting

The economic situation – and its consequences for outsourcing – is undoubtedly serious. Yet if service providers and clients grasp these changes early, current conditions could trigger improvements in sourcing relationships that will benefit both parties.

Firstly, the new fiscal conditions mean that both parties have an increased incentive to achieve value evenly over the lifetime of the contract. Cost savings will no longer be achieved through the mirage of financial engineering. Instead, both parties will be challenged to deliver savings through long term improvement initiatives, economies of scale, adherence to standards and optimised service delivery and relationship management.

With discounts gone, the new outsourcing paradigm is putting pressure on client organisations to contribute to improving performance in order to achieve savings alongside their service provider.

Early signs are that the best performing clients are willing to let their service providers implement change in order to achieve either economies of scale or standardised delivery. Inefficient processes, often inherited as part of the deal, are a significant burden to delivery operations. They can increase cost by up to 25 per cent above the market rate and often deliver no benefit.

In a client organisation last year, for example, Compass found that eight per cent of the cost of a large outsourcing contract was caused by a combination of outdated processes and unwillingness to enforce appropriate behaviour. Following this analysis, collaborative change initiatives between vendor and client have achieved previously untapped savings, which went straight to the bottom line of that business.

In the new outsourcing paradigm, savings are going to be achieved through a CIO’s frugality at home rather than through the generosity of vendors with their sorely crunched credit.